9/22/2009 @ 3:15PM

Strength Through Diversification

In an era I call B.F.C.–Before the Financial Crisis–most financial advisors encouraged you to use your birthday as a guidepost and invest about the same percentage as your age in fixed-income instruments and the rest in stocks or equity mutual funds, plus a nip and tuck of about 5% for cash. When it came to aggressive growth instruments, the rule of thumb was: “If it keeps you awake at night, don’t do it”–as if risk tolerance were a function of your personality type.

But the rules of diversification and risk-taking have changed in the post-financial crisis. Women, as well as men, can’t afford to go steady with just one or two asset classes. Everyone who wants to grow their portfolios while also avoiding sleepless nights must learn about new subcategories within the main asset classes and new techniques for spreading risk. That way they can expect at least one or two categories to rise if the others fall. Here are six portfolio strategies to preserve capital and spur growth.

Imitate the Ivy Endowments

You’ve likely heard about how the Harvard and Yale endowments had great track records for beating the markets by spreading their holdings across a wide range of asset classes–before the financial crisis hit them hard. Most university endowments are facing losses of 25% to 30% for fiscal year 2009, in step with the Dow Jones industrial average, which lost 25% of its value between June 2008 and June 2009.

So why are investment advisors still telling clients to emulate the Ivy endowments? It’s because they still offer useful lessons in risk management, especially if you create a simpler version of an Ivy League portfolio that doesn’t include private-equity holdings, which played a big role in bringing these portfolios down over the past year. Over the long term, Yale’s endowment returned an average of 16.62% annually between 1985 and fiscal 2008, while Harvard’s endowment returned more than 15% a year over the same period. By comparison, the S&P 500 returned only 11.98% annually during that time.

Mebane Faber, a portfolio manager at Cambria Investment Management in Los Angeles, designed a model portfolio that mimics Harvard’s and Yale’s, mostly by using exchange-traded funds (ETFs). Faber’s model allocates between 15% and 30% to each of five categories: U.S. stocks, foreign stocks, bonds, commodities and real estate investment trusts. If an asset fell short of its 200-day average performance, Faber would sell it and go to cash, then get back in when the asset moved above its 200-day average. He notes that in recent years both endowments held less than 15% of their portfolios in U.S. stocks.

Faber’s portfolio would have followed a similar tactic; he says he would have had clients out of stocks entirely in January of 2008, with 80% of their holdings parked in cash and bonds by October 2008.

You don’t have to go whole-Ivy to use ETFs for some of your equity, bond and alternative positions. Like a mutual fund, an ETF gives you a small stake in a dozen or more companies at one time, but most ETFs are passively managed and follow a benchmark instead of trying to beat it. And the fees are lower–the average expense ratio is 0.56%, vs. 1.44% for mutual funds.

This isn’t to say that you can’t lose money in ETFs. There are more than 700 ETFs available now, and the more esoteric ones can take you on a roller-coaster ride. But if you stick to the ETFs that track major asset classes, you’ll find they can help round out your portfolio in various sectors without exposing you to the risk you take with individual stock holdings.

Dividends Are Back

It is still wise to hold about 40% to 60% of your portfolio in equities, so pick stocks that reward you the old-fashioned way: with dividends paid out every quarter.

Since the technology boom of the late 1990s, investors have tended to pay less attention to dividend yields–the annual dividend per share divided by the current price–favoring instead low price-to-earnings ratios. But so many earnings turned out to be inflated in the 2006­-07 bubble that P/E ratios only looked low.

Dividends don’t fluctuate the way earnings do. Gayle Buff, founder and principal of Buff Capital Management in Boston, says she is looking for “large-cap multinational companies with high dividend yields and not a lot of debt.” Keep an eye out for stocks that beat the average dividend yield offered by the S&P 500, currently around 3.2%.

Emerging Markets Are Still Emerging

About 10% of your equity allocation should be in international stocks or funds, with an emphasis on developing countries. Even though the recession has clobbered both China and India–since their economies depend to a large extent on exporting to the U.S.–they’re both expected to attain gross domestic product growth of just over 7% in 2009, vs. only 3% for the global economy overall, according to the World Bank. In addition, China and India are increasingly driving the global demand for oil and other commodities, so you might consider plays in industries or countries that supply them.

Keep Your Bonds Short-Term

Financial advisors generally recommend holding about 30% to 40% of a portfolio in fixed income right now, but only in bonds that will mature in five years or less. Sometime in the next five years interest rates will climb, and the bonds you buy today will lose value.

The credit crisis has made high-grade corporate bonds, which have ratings of AA or AAA, the bonds of choice for all but the most intrepid buyers because the risk of default is still slim. But certain floating-rate bonds, which reset their interest rate every 90 days, are a good short-term play that could pay off as interest rates rise, according to Aaron Schindler, a managing director at Wealth Advisory Group in New York.

Since they are BB grade, however–which places them in the high-yield or “junk bond” category–they should make up only 5% or 10% of your bond allotment, Schindler advises. The easiest way to buy them is through floating-rate bond mutual funds, such as the Fidelity Floating Rate High Income Fund (FFRHX) or the Eaton Vance Floating Rate A Fund (EVBLX).

Municipal bonds looked more attractive earlier this year when President Obama, fresh from his election victory, talked about spending federal money on infrastructure projects to stimulate the economy. Since then, many municipal bonds have gone into default as a result of state and local governments being strapped for cash. Brenda Wenning, who runs Wenning Investments in Boston, advises sticking mostly to securities issued by state governments with strong economies. Smaller municipalities or troubled school districts are riskier bets, she believes.

Alternative Assets Are the New Black

Commodity and currency futures and options used to be the provenance of institutional investors because the entry costs were high and prices rose and fell with the whims of politics, weather and other uncontrollable forces. Now, however, many investment advisors are putting 10% to 20% of their retail clients’ portfolios into these alternatives, often using ETFs to lower the costs.

Commodities, though forever volatile, are likely to move in the opposite direction of the stock market and rise when an inflationary cycle comes.

Gold is one commodity that everyone is talking about. A portfolio allocation of 5% to 10% in this precious metal is one way to hedge against further declines in the U.S. dollar as well as the inevitable inflation ahead. The easiest way to invest in gold is through the SPDR Gold Trust (GLD), which buys bullion directly.